what is a “long-term hold”?

I was listening to radio news yesterday morning when a commentator from the Wall Street Journal  said that many brokerage house analysts are beginning to recommend both Amazon (AMZN) and Apple (AAPL) as “long-term holds”.

What does this mean?

Well, it’s not a compliment.  It’s a way saying “sell” while not putting the word in print.

Why would an analyst be so indirect?    …because if his recommendation on a company’s stock  is “sell,” then the company in question is likely to deny him access to company information, refuse to return his phone calls, decline to appear at conferences he organizes (see my post)  …and do any other stuff it can think of to hurt his career.

Extremely petty, it’s true.  But it happens.  At least with the “hold” recommendation the analyst has a shot a plausible deniability.  He can say to the CEO or CFO that the company is so spectacular that its stock is temporarily overvalued.  All his recommendation is meant to convey is that investors should wait for a slightly lower entry point.

Of course, that’s not what “long-term hold” means.  It’s broker-speak that can be broken down into two parts:

–“long-term” means there’s absolutely nothing attractive about the stock in the short term–meaning the next year or so.  At best, the stock will be dead money.

–“hold” means the stock is not a “buy.”  Over the time frame specified, the stock will likely move in line with the market.

Therefore,

–“long-term hold” means the stock in question is dead money in the short term and, in addition as far forward as the mind can imagine there’s no reason to think the stock ever has a chance to outperform the market.

So, although the term sounds innocuous, in practical terms there’s no worse recommendation than this.

Of course, we can take the discussion one step farther and ask whether analysts’ recommendations have any predictive value.  My take:  analysts typically know a lot about the companies they cover and the industries they’re in.  Only a very few know much about how the stock market behaves.  A lot of times, their recommendations are lagging indicators.

new financing for J C Penney (JCP)?

the news

During New York trading last Friday, CNBC reported that Goldman had lined up $1.75 billion in new debt financing for JCP.  The stock, which had already been rising strongly on news that the Soros-run Quantum Fund had acquired a 7.9% stake in the ailing retailer, jumped sharply.  JCP ended the day at $17 a share, up 11.6% on the day.

According to the Wall Street Journal, which isn’t 100% clear, the new loan to have the following characteristics:

–$1.75 billion in size

–a five-year term, after which repayment in full would be due

–a 6.5% interest rate, implying $113.75 million in annual interest expense

–secured by many/most/all the company’s assets not already acting as collateral for other loans.

Neither JCP nor Goldman have confirmed the press reports.  As of Sunday night, when I’m writing this, there’s no SEC filing about this on the Edgar site, either.

my thoughts

1.  From the WSJ account, this new financing appears to be a bond offering rather than a bank loan.   Two differences:   on the one hand, the loan must be made all at once, starting the clock on interest payments, even though the money might not be needed right away; on the other, the lender has, generally speaking, no right to ask for early repayment.

The cost of the financing–before Goldman’s fees– would be close to $570 million over the next five years.

Unlike a bank loan, which can have an indeterminate term, JCP would have to have $1.75 billion available to repay the loan five years from now.  It’s possible that JCP could negotiate an extension, or borrow from someone else to get the money.  Without one or the other, the loan would seem to put a time limit on how quickly the operational turnaround must occur.

2.  To the extent that any assets of JCP serve as collateral for the loan, they would presumably not be able to be sold without the lender’s permission.  This could prove another, possibly severe, limitation to JCP’s options.

In a related story, the WSJ cites a brokerage report by ISI.  The report, which I haven’t seen, asserts that if the top 300 of the properties JCP controls were rented to third-parties instead of being used by JCP, they would fetch yearly rental income of $1.2 billion.  That’s more money than JCP has made in any of the past five years!

I don’t know whether this figure is correct.  If it is, it suggests that even pre-Ron Johnson the value of Penney’s real estate was being frittered away supporting a retail operation that only turned a profit because of a massive rent subsidy.

I’m sure JCP situation is much more complicated than just shutting down retail and allowing the value of the company’s real estate to be recognized–especially now that JCP stores have absorbed so much damage in the recent past.  Still, the point is that accepting the new loan might close out completely the possibility of forming a separate entity with these properties and rerenting them.

It will be interesting to see what JCP chooses to do.

Quantum Partners, the George Soros investment vehicle, has acquired 7.9% of JCP

the filing

Yesterday, Soros Investment Management LLC, the manager of the Cayman Islands-based Quantum Partners, filed a Schedule 13-g with the SEC.  It declares Quantum now owns 17.4 million shares, or 7.9% of the outstanding shares, of J. C. Penney (JCP) common stock.

What does this mean?

the basics

An institutional investor is required to file a Schedule 13-g within 10 days after having acquired 5% of a company’s common stock.  Soros IM crossed that threshold on April 15th.  It must make follow-up filings whenever it brings its stake up or down by .5% of the outstanding.  The disclosure requirement ends when the holding falls below 5.0%.  Mutual funds do this all the time.

The 13-g differs from Schedule 13-d, which is filed by basically anyone other than a portfolio investor.  That schedule requires the filer to state his intentions–for example, to obtain control of the company, or to take an active part in its management.  The 13-g requires no such declaration, because the presumption is that the portfolio manager has no such intentions.

Assuming his contracts with his clients permit, the filer can always change his mind, however.  He signals this by filing a 13-d.

what we can conclude

I think the conclusion the financial press has drawn that Soros IM is a purely passive investor is unjustified.  The firm is that for now, but it can always alter its stance simply by filing a 13-d.

The stake represents and investment of about $250 million.

It’s unclear whether Soros is finished buying.  Usually, investors amassing a large stake in a publicly-traded company accumulate as much as they can without attracting attention during the ten days of anonymity they have after they hit the 5% mark.  Presumably the 17.4 million shares represents the Soros IM holding as of yesterday.  If so, we won’t know for about two weeks whether he’s continuing to purchase shares in significant amounts.

Importantly, if–as the filing states–the Soros stake represents 7.9% of JCP’s shares, this means the total outstanding must be 219.8 million shares, more or less.  This is the same number listed in the 10-k as outstanding on February 2nd, the end of the latest fiscal year.  In other words, Soros has bought its stake on the open market, not from JCP.  Therefore, JCP is not getting a cash infusion from Soros IM.  The money went to existing shareholders who are cashing out.  JCP still needs to raise money from outside sources.

does the move help JCP?

Arguably, JCP would have been best off if Soros IM had bought new shares from JCP, instead of already existing shares on Wall Street.  That way the quarter-billion dollars would have gone into Penney’s bank account.

Maybe Soros IM tried to buy shares from the company and was rebuffed.  More likely, in my view, Soros IM concluded it should seize the moment and buy while the stock price was weak.  Soros IM may well also be willing to be a buyer in any future securities offering JCP may make.  On the other hand, Soros IM has a very useful block of stock that could be sold to a new activist eager to enter the picture.

The Soros IM move consolidates the ownership of JCP further.  On the one hand, the probably makes it easier to obtain a majority vote.  On the other, it could end up adding another big ego to the boardroom.

the Soros record?

Are the Soros IM portfolio managers good stock pickers?  Is their purchase of JCP a sign that the company is a significant bargain.

I don’t know.

Most of what I know about George Soros comes from his 1987 book, The Alchemy of Finance. It’s a combination of a statement of his general investing principle (which he calls reflexivity) and a long account of his day-by-day musings about the financial markets.   I could only make it about halfway through.

Two things struck me, though:

–Mr. Soros included on the inside covers a multi-year performance record.  It consists of short periods of daring and brilliantly successful currency speculation–and long periods of continuing equity underperformance.

–the second is a petty point, but apparently not one that’s beneath me.  In the book Soros outlines his principle of reflexivity.  He calls it his original contribution to Western philosophical thought, which he put to use in financial markets after developing it as an abstract philosophical concept.  I was stunned when I read this.  Reflexivity is actually the dialectical method Hegel put forth in the early nineteenth century (take the famous description of the  evolving and reversing relationship between master and slave in the Phenomenology of Mind, for example).  These ideas were later applied to economics by Hegel’s follower Karl Marx.  Is it possible that, although he calls himself a philosopher and was educated in Europe, Soros just wasn’t aware of the most influential European thinker of the nineteenth century?  Or is he the master salesman, who figures no one will know?

Either way, not much to inspire confidence.

To the JCP point, my guess is that at the age of 82 Mr. Soros no longer plays the leading role in Soros IM investment decisions.  While I personally would hesitate to ride on Mr. Soros’s coattails, despite his fame, it’s unclear to me who exactly had the inspiration behind the JCP purchase.

My bottom line:  JCP now has what amounts to a celebrity endorsement.  It’s from a party whose stock-picking prowess is unclear and who, at least for the moment, is a passive investor.  Were Soros IM clearly supportive of Mr. Ackman et al–according to the New York Times, the two parties have offices in the same building–it would have bought its shares directly from JCP, in my opinion.

Therefore, the stake is potentially destabilizing, even though the filing of a 13-g implied no present activist intentions on Soros’s part.  One positive scenario for third-party shareholders would be if the Soros presence somehow triggered a struggle for control of JCP that drove the stock price higher.  The worst case would be if JCP depleted its cash in buying Soros out.

Personally, I’m going to watch from the sidelines.

 

AAPL’s 2Q13–some answers, still some questions

the report

After the New York close yesterday AAPL reported its 2Q13 earnings results (AAPL’s fiscal year ends in September).  Revenues were $43.6 billion, up 9% year-on-year.  EPS, however, were down 18% yoy, at $10.09.   The latter figure was slightly ahead of the Wall Street analyst consensus of $9.97, a number that been ratcheting down in recent weeks.

The company guided to flattish sales in 3Q13, with mild margin contraction.

It announced a 15% increase in the quarterly dividend to $3.05 a share, meaning a current dividend yield of just over 3%.

APPL also intends to buy back $60 billion in stock before the end of calendar 2015.  That would be 15% of the company at current prices.  AAPL now has $147 billion in cash, of which $104 billion is held outside the US.  It won’t touch the foreign holdings for the buyback.  Instead, it will issue bonds in the US to get the money it needs.

This piece of financial engineering will have two impacts.  It will boost the growth rate of EPS by at least an additional 5 percentage points per year.    And the financial leverage will increase AAPL’s return on equity from its already heady 25%+.

The stock was initially up about 5% on this news.  Then, during the conference call, AAPL management said it won’t have its next new product launch until fall.  The gains evaporated and were replaced by a slight loss.

what’s going on

Two factors:

margin erosion

1. smartphones

As I see it (remember, AAPL is pretty opaque), the emergence of Samsung as a competitor in the high end of the smartphone market,where AAPL makes its biggest profits, has caused that segment to mature faster than AAPL had expected.  Unit volume growth is now coming mainly from emerging markets, where the price of AAPL’s cutting-edge phones is too high.  The company is selling older models (iPhone4s) there, at discount prices–and therefore reduced margins.

2. tablets

A year ago, it looked to me like 2/3 of AAPL’s tablet volume was from its newest model iPads.  Today, unit volumes are much higher, but less than a quarter are the newest 10″ iPads.  The rest is a combination of iPad minis (a runaway success) and bulk sales of iPad2s to institutions.   Both of the latter are at lower margins.

My guess is that we’re at or near a gross margin low point now.

continuing PE multiple contraction

The maturing of the smartphone market has been actively discussed in the financial community for a couple of years.  In my view, worry about this possibility is the main reason that, despite booming sales and earnings, the price earnings multiple on AAPL’s stock had contracted from the high teens to around 12 by the second half of last year.  Relative to the market, the multiple went from a premium of 25% to a discount of 25% over the same time period.

Unpleasant for holders, maybe, but understandable.

Over the past 6-8 months, however, the multiple has contracted further, both in absolute terms (to under 10) and relative (to a discount of more than 40%).  In fact, yesterday’s Wall Street Journal had an article comparing AAPL with HWP and DELL.  That’s kind of like comparing night and day–the single thing I can see that ties AAPL to these two truly terrible companies is the similarity of their price earnings multiples.

Yes, when fast growers begin to slow down, the PE contracts, often violently.  And because a good portion of the contraction is an emotional thing, the multiple shrinkage is usually greater than one would expect.  But even seeing this process over and over, I didn’t imagine that a fundamentally sound company like AAPL could be trading at 9x in a market trading at 15x.

where to from here?

Note, first, that I’ve been wrong about the stock for a while.

I think the stock buyback makes economic sense, and it will probably at least stabilize the AAPL stock price.  I don’t think the addition of debt to the capital structure will have any effect.

It may be a big stretch, but to me the 15% dividend increase says that’s what AAPL’s board expects its earnings growth rate over the next few years to be, financial engineering aside.  I think that’s a reasonable assumption, and could be conservative.

AAPL management would do the most for its stock by being more forthright with investors about current business challenges and how it plans to deal with them.  That’s not likely, however, if the 2Q13 earnings call is any indication.

That leaves holders waiting for new product announcements–and subsequent earnings acceleration–at summer’s end.